Artisan Partners Asset Management (APAM) manages mutual funds and separately-managed portfolios of securities; its employs nine autonomous investment teams, explains Doug Gerlach, editor of Investor Advisory Service.

The teams are given the flexibility to develop their own processes with the mandate to deliver excellent investment returns to clients. We are attracted to the stock for three primary reasons:

• First, the company pays an 8.6% dividend approximating 80% of cash flow, so it is almost like shareholders are partners in the business.
• Second, it is developing a focus on market niches to help insulate it from fee pressure and trends toward passive management.
• Third, the valuation appears compelling at a trailing P/E only slightly above its typical low P/E.

Teams are located in New York, Chicago, San Francisco, Denver, and Milwaukee. Each team can manage more than one “product” within its discipline.

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Some teams are fairly generic like “Growth” (33% of assets under management or “AUM”) or “U.S. Value” (5% of AUM). Other mainstream teams include “Global Equity” (20%), “International Value” (15%), and “Global Value” (14%).

Even in these common categories, products span the capitalization spectrum rather than focusing merely on large cap companies. The remaining 13% of AUM consists of rapidly-growing opportunities in credit markets, emerging markets, and thematic investing.

All of its fund teams have outperformed their benchmarks since the inception of their strategies. 43% of its mutual funds carry a five-star rating by Morningstar. Its only fund rated two stars still beat its benchmark over the past one, three, five, and ten years.

Almost all of Artisan’s AUM consists of equities, with about half in non-U.S. securities. Its global focus, along with 13% exposure to less common categories, offers the potential for some relief from constant fee pressures facing most active asset managers. Assets are split pretty evenly between institutional accounts and mutual funds. Its largest institutional account comprises 7% of the total AUM.

Employees own 14% of Artisan shares and are party to a shareholder agreement requiring shares to be voted as a block on matters put to a shareholder vote. Employees are allowed to sell up to 15% of their holdings each year or $250,000 worth of stock, whichever is greater. Employees may also own shares in subsidiaries, primarily Artisan Partners Holdings LP, the primary operating subsidiary of publicly-traded Artisan Partners Asset Management which owns 80% of the LP.

From time to time APAM has offered additional shares for sale, the proceeds of which have generally been used to retire minority holdings of the LP, thereby increasing APAM’s share of the partnership’s earnings.

Many employees receive stock-based compensation and/or incentive pay that is invested in one or more of the company’s investment strategies. 4% of annual revenue is targeted toward incentive awards. The cost of Artisan’s incentive compensation program is significant and seems to absorb what would otherwise constitute expense leverage at other investment firms. Employees are effectively partners in the company alongside shareholders but without having their own capital at risk.

Under its Dividend Policy, the company pays out 80% of quarterly free cash flow as dividends to shareholders. It considers special annual dividends if the remaining cash is not required for growth initiatives or general corporate uses.

Artisan Partners’ incentive compensation program and its focus on differentiated corners of the investment market have paid off with strong investment performance for clients and dividends plus growth for shareholders. However, a lack of meaningful earnings retention reduces growth opportunities.

If its long-term revenue growth of 6% continues, we expect only modest leverage due to incentive compensation expenses. EPS growth of 8% per year could lead to $7.30 in five years. A return to its typical high P/E of 14.0 could result in a doubling of its share price plus substantial dividends. The potential total annual return exceeds 23%.

We estimate a downside risk of 33% in the event of an EPS decline of greater than 30% from recent levels during a modest bear market. The downside is softened by a trailing P/E of 9.1 that only slightly exceeds its typical low P/E of 8.9.